Tozi Gugu owns a newly-issued ten-year South African government Treasury bond and wants to evaluate the sensitivity of its cash flows to interest rate changes. The bond has a sinking fund whose terms require that the principal be amortized at a constant rate over the last five years of the bond. Thus, sinking fund payments are scheduled to begin at the end of the sixth year and are payable directly to the trustee to the indenture. Bond investors expect to be paid the principal amount of the bond at its maturity. The coupon rate of interest is 9% payable annually, and each bond has a face value of ZAR 1000. Investors' required rate of return on bonds with a similar risk is 12%.

Tozi has predicted the following interest rate scenario:

Interest rates simultaneously decline by 250 basis points for all maturities, remain there for one year and then,

Interest rates simultaneously increase by 350 basis points for all maturities and remain there for the next year.

Currently, the Treasury bond is priced close to par and the yield curve is "flat." Tozi does not expect the shape of the yield curve to change during her interest rate scenario.

Required:

a). (1) State whether, in the interest rate scenario described, the Treasury bond's cash flows

Increase or decrease in the first year

Increase or decrease in the second year. (No calculations required) .

(2) Discuss the reason why the bond's cash flows change.

b) Tozi also wants to evaluate the price sensitivity of her bond to changes in interest rates. She knows that the modified duration and the convexity are two possible measures she could use to evaluate price sensitivity.

(i) Select and justify with one reason which measure Tozi should use to evaluate the price sensitivity of her bond.

(ii) Would it be theoretically correct to use any of the above measures in isolation? Why or why not?